The best and worst case scenarios

The best case scenario: The bad banks continue to be bought up, there is no run on hedge funds next Tuesday, only mid-sized European banks fail, money market funds keep on buying commercial paper, and the Fed and Treasury continue to operate on a case-by-case basis. Since Congress doesn’t have to vote for something called "a bailout," it can give Paulson and Bernanke more operational freedom than they would have otherwise had. The American economy is in recession for two years and unemployment does not rise above eight or nine percent.

The worst case scenario: Credit markets freeze up within the next week and many businesses cannot meet their payrolls. Margin calls cannot be met and the NYSE shuts down for a week. Hardly anyone can get a mortgage so most home prices end up undefined rather than low. There is an emergency de facto nationalization of banks to keep the payments system moving. The Paulson plan is seen as a lost paradise. There is no one to buy up the busted hedge funds, so government and the taxpayer end up holding the bag. The quasi-nationalized banks are asked to serve political ends and it proves hard to recapitalize them in private hands. In the very worst case scenario, the Chinese bubble bursts too.

I still think some version of the best case scenario is more plausible, but I wish I could tell you I am sure.

Let’s add to the best case scenario: better decision-making practices by financial institutions in the long run (and less moral hazard due to the apparent political difficulties of getting an industry bailout), a less bubbly housing market in the future, and more flexibility for fiscal stimulus in the short run(without 700bn tied up in holding risky bad assets). The long run could be a world where the government has to put out fewer fires in which it may have helped fuel.

A smaller, more efficient (albeit less risky) financial sector might not be so bad either for sustainable long run economic growth.

The recent financial crisis kept reminding me of Katrina — the levee is breaking here and there, how many sand bags should we throw out to stop the leak? Will the levee fail catastrophically? Should people be evacuated? How long will it take for the city to recover from a flood assume there will be one? And once recovers, will it still be the same? …

Once a mind is set on an analogy like this, the worst case scenario is ugly.

There is no one to buy up the busted hedge funds, so government and the taxpayer end up holding the bag.

Wait, why would we have to do that? I can understand with huge banks — there’s all that counterparty risk from transactions that flow through them. Are hedge funds comparably central to the operation of the markets? Couldn’t we let them collapse?

Economist Jeffrey Miron says the bailout plan presented to Congress was the wrong solution to the crisis

CAMBRIDGE, Massachusetts (CNN) — Congress has balked at the Bush administration’s proposed $700 billion bailout of Wall Street. Under this plan, the Treasury would have bought the “troubled assets” of financial institutions in an attempt to avoid economic meltdown.

This bailout was a terrible idea. Here’s why.

The current mess would never have occurred in the absence of ill-conceived federal policies. The federal government chartered Fannie Mae in 1938 and Freddie Mac in 1970; these two mortgage lending institutions are at the center of the crisis. The government implicitly promised these institutions that it would make good on their debts, so Fannie and Freddie took on huge amounts of excessive risk.

Worse, beginning in 1977 and even more in the 1990s and the early part of this century, [the Democrats in] Congress pushed mortgage lenders and Fannie/Freddie to expand subprime lending. The industry was happy to oblige, given the implicit promise of federal backing, and subprime lending soared. [We can thank Chris Dodd, Barney Frank, Pelosi, et al, for this.]

This subprime lending was more than a minor relaxation of existing credit guidelines. This lending was a wholesale abandonment of reasonable lending practices in which borrowers with poor credit characteristics got mortgages they were ill-equipped to handle.

The fact that government bears such a huge responsibility for the current mess means any response should eliminate the conditions that created this situation in the first place, not attempt to fix bad government with more government.

The obvious alternative to a bailout is letting troubled financial institutions declare bankruptcy. Bankruptcy means that shareholders typically get wiped out and the creditors own the company.

Bankruptcy does not mean the company disappears; it is just owned by someone new (as has occurred with several airlines). Bankruptcy punishes those who took excessive risks while preserving those aspects of a businesses that remain profitable.

In contrast, a bailout transfers enormous wealth from taxpayers to those who knowingly engaged in risky subprime lending. Thus, the bailout encourages companies to take large, imprudent risks and count on getting bailed out by government. This “moral hazard” generates enormous distortions in an economy’s allocation of its financial resources.

Thoughtful advocates of the bailout might concede this perspective, but they argue that a bailout is necessary to prevent economic collapse. According to this view, lenders are not making loans, even for worthy projects, because they cannot get capital. This view has a grain of truth; if the bailout does not occur, more bankruptcies are possible and credit conditions may worsen for a time.

Talk of Armageddon, however, is ridiculous scare-mongering. If financial institutions cannot make productive loans, a profit opportunity exists for someone else. This might not happen instantly, but it will happen.

Further, the current credit freeze is likely due to Wall Street’s hope of a bailout; bankers will not sell their lousy assets for 20 cents on the dollar if the government might pay 30, 50, or 80 cents.

The costs of the bailout, moreover, are almost certainly being understated. The administration’s claim is that many mortgage assets are merely illiquid, not truly worthless, implying taxpayers will recoup much of their $700 billion.

If these assets are worth something, however, private parties should want to buy them, and they would do so if the owners would accept fair market value. Far more likely is that current owners have brushed under the rug how little their assets are worth.

The bailout has more problems. The final legislation will probably include numerous side conditions and special dealings that reward Washington lobbyists and their clients.

Anticipation of the bailout will engender strategic behavior by Wall Street institutions as they shuffle their assets and position their balance sheets to maximize their take. The bailout will open the door to further federal meddling in financial markets.

So what should the government do? Eliminate those policies that generated the current mess. This means, at a general level, abandoning the goal of home ownership independent of ability to pay. This means, in particular, getting rid of Fannie Mae and Freddie Mac, along with policies like the Community Reinvestment Act that pressure banks into subprime lending.

The right view of the financial mess is that an enormous fraction of subprime lending should never have occurred in the first place. Someone has to pay for that. That someone should not be, and does not need to be, the U.S. taxpayer.

The German economy has always prized stability and efficiency over wild growth and risk. When the wall came down and they absorbed East Germany, most experts said they’d never recover. But the Germany economy is based on making quality goods and selling them at the right price. They are stable, and just plug along, without a lot of fanfare but without a lot of bubbles and busts.

It’s like the carburetor vs. fuel injector. The fuel injector is higher tech, more efficient… but you can’t rebuild one if it goes.

“Talk of Armageddon, however, is ridiculous scare-mongering. If financial institutions cannot make productive loans, a profit opportunity exists for someone else. This might not happen instantly, but it will happen.”

A quick question: is there evidence that the credit markets are right now freezing or is this just a concern about what may soon happen?

I am having a hard time understanding all of this so pardon my ignorance on such a basic question. I have heard that Federal Reserve data suggests that loans are still being made in abundance that the vast majority of regional and local banks are still on firm footing. Is the problem simply that certain large banks are in trouble and is the solution for smaller banks to bring together lenders and creditors.

When the wall came down and they absorbed East Germany, most experts said they’d never recover.

Funny, that. I saw Paul Volcker speak in 1988 or 1989 – during the course of his speech, he mentioned that he suspected that Germany would overtake the US, economically, rather than Japan, which concern was prevalent at the time.
German reunification obviously threw a wrench into that, but, as you suggest, it may not have been permanent.

Today we have the best case, the worst case, and the nightmare case. For the nightmare scenario try an electoral sweep for Obama that gives the Democrats a mandate to pass the New New Deal which results in the Great Great Depression lasting until World War III.5 is necessary to pull us out. Now put that in your pipe and smoke it.

No one has given any complete details of what would really happen with, or without the bailout, only general details. If you have to borrow money/present a project/etc., you have to give details of the pro/cons of why you need the money. NO ONE HAS DONE THAT, so why should the taxpayers have to be responsible for the BUSH and other High Paid people’s BAILOUT….

Um… it isn’t just about subprime loans, if it was, the entire financial system wouldn’t be melting down. We’ve had housing bubbles before. The reason why this one might collapse our financial sector is because of Republican sponsored deregulation of the financial markets in the early 90’s. In that legislation, depression era firewalls between securities, banks, and insurance were removed. The mess we are in are because sub-prime lenders repackaged their debt and sold it as securities. This gave the lenders the incentive, much more than expansion of the CRA, to make more sub-prime loans, because they could profit by selling these as securities, not just be hoping the lendee paid the loan back with interest. They had collusion with insurance companies, who insured these bad repackaged loans, and with risk rating companies who ignored the risk of an overall housing downturn (the one thing that could and did sink the whole scheme). Everyone who was making a mint in this mess was lobbying Republicans and Democrats to prevent them from regulating these things. Phil Gramm, for instance, made nearly a million dollars lobbying to prevent mortgage industry regulation in the early 2000’s. It may feel good to pretend like this is all the fault of one party, but its not. A solution to the problem, only based on mortgages, isn’t going to prevent a meltdown. It will just delay it. There is more bad debt out there, that has been repackaged as securities, from credit cards and other kinds of loans. Until the underlying issue, caused by deregulation is fixed, we are going to have a series of other shoes dropping.

SO the question its? who has all the money at the end of the food chain, cause I don’t think money can evaporate like water and then come back again, who its holding it?, not me, not you of course, so everything its b.s. of course. just a tought .